When trying to work out what a business might earn a decade from now, most investors extrapolate from the past couple of years. Its a blunt tool, though, and everyones using it.

When Intelligent Investor sprang into existence a decade ago, no-one could have foreseen what it might look like today. None of the analysts who work here now (in 2008) were around in 1998 and it could barely even have been considered a value investing publication. Things have certainly changed, but that’s all part and parcel with a start-up business. Predicting what large established businesses might be up to in ten years’ time is more doable, although it’s certainly not easy. It’s worth trying, though, because a focus on what such businesses might be earning a decade from now, rather than next month, will likely lead to some great long-term investments if it’s done well.

But there’s a little quirk hard-wired into our brains that makes it more difficult than it might seem, and that’s our tendency to extrapolate from recent events. It explains why you’re much more likely to get caught umbrella-less if it hasn’t rained for a month, and why you’re more likely to change the route you drive to work today if you got caught in a traffic jam yesterday.

It works most of the time

Generally speaking, extrapolation from the recent past works pretty well – which explains why we do it, often at a subconscious level. It’s a pretty blunt tool, though, and it’s the same one everyone else is using, so it will often lead you into poor investment decisions. However, if you understand the human tendency to extrapolate – particularly your own – then you’ll be well-placed to profit from others’ folly. Our experience with Flight Centre over the past few years is a fine example of this, but as we’ve dissected that investment many times we’ll go for something different this time.

ARB in 2004

Year to 30 June

2000

2001

2002

2003

2004

EPS (cents)

9.2

11.4

13.1

16.3

19.2

EPS growth (%)

N/A

24

15

24

18

In late 2004, with the help of the previous few years’ earnings results, even Blind Freddy could have seen that four wheel drive accessories manufacturer ARB Corporation was a good business. Its slowest rate of growth in the preceding five years had been 15%. It was obviously a good company, which is why it wasn’t cheap when we reviewed it on 26 Oct 04 (Hold – $4.18).

ARB come 2006

Year to 30 June

2005

2006

EPS (cents)

19.3

20.0

EPS growth (%)

1

4

But the next two years delivered a blow. Rising oil prices (leading to declining four-wheel drive vehicle sales), rising steel prices and skilled labour shortages really dented the growth rates. So the market, and most interested individuals, extrapolated from these new numbers, with the result that the share price plunged during this period – to as little as $2.60 in January 2006.

The reality was different

But those who focused on the company’s operations, notably its push into more fuel efficient vehicles and its new plant in Thailand, had the opportunity to see that management was working on effective answers to all these problems. The numbers didn’t tell the full story. But it takes some fortitude and a deliberate effort to overcome the urge to extrapolate. Even if you’re totally focused on how the business might look in 2015, it’s hard to say ‘I expect ARB Corporation’s earnings per share to grow in excess of 10% per year’ when you have this sort of ‘evidence’ staring you in the face. Fortunately, we knew the situation well enough to make that leap of faith.

ARB today

Year to 30 June

2007

2008 forecast

EPS (cents)

23.7

27.0

EPS growth (%)

19

15

Now things are looking better and the growth is becoming more obvious again. But with the share price still trading at prices similar to late 2004, despite EPS having grown significantly, there’s still value in this stock. But let’s focus on the lesson on offer. The most recently reported numbers don’t tell us a lot about how a business will grow or shrink over a decade. In fact, sometimes they can be downright misleading. But they tend to worm their way into our heads and influence our thinking, leading us to put too much weight on their importance. If you actively fight this urge, you’ll become a better investor and a richer one come our 20th birthday.

Not all past theory

Of the stocks I cover, the most obvious current example of extrapolation leading investors astray is at Corporate Express. We made our case more completely on 21 Feb 08 (Long Term Buy – $5.56), but the essence of it is that the company’s sales growth in the past few years has slowed considerably. The market appears to be extrapolating those low growth rates for the next decade. With last year’s sales growth coming in at 5%, it caused no surprise when I came across a broker report that predicted sales growth over the next three years for Corporate Express of 5.4% per year – it’s human nature. But I disagree with the market’s prognosis. I think it’s reasonably predictable that the average sales growth rate over the next decade will pick up. It won’t grow fantastically but it should beat GDP growth by a good few notches. It’ll be a few years before we know for sure who’s right, but in the meantime we’re likely to upgrade our recommendation if the market gets any more pessimistic. Take your cues from your own reasoning on matters within your circle of competence, and be aware of the human tendency to extrapolate, and the pitfalls it can create. And we’ll reconvene in a decade to discuss some of the wonderful opportunities such an approach will have delivered.

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